Dan Ariely

Here is an excerpt from an article written by Dan Ariely for the Harvard Business Review (March 2011 issue). To read the complete article, check out other articles and resources, and/or sign up for a free subscription to Harvard Business Review’s Daily Alerts, please click here.

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Imagine that you and I meet at a party, and I tell you about my research on behavioral economics. You see opportunities to use the principles to improve your business and think we could work together. You have two options: You can ask me to collaborate, with a handshake promise that if things work out, you’ll make it worth my while. Or you can prepare a contract that details my obligations and compensation, specifies who will own the resulting intellectual property, and so on.

For most of you, the decision is obvious. The second approach, the complete contract, is the way to go. But should it be?

The idea of making a deal with a handshake—what we generally call an incomplete contract—makes most of us uncomfortable. A handshake is fine between friends, but when it comes to vendors, partners, advisers, employees, or customers, we believe that incomplete contracts are a reckless way to do business.

Indeed, firms try to make contracts as airtight as possible—specifying outcomes and contingencies in advance, thus lowering the chances for misunderstanding and uncertainty. But complete contracts have their own flaws, and business’s increasing dependence on (I would say, fetish for) absurdly detailed contracts in every situation comes with its own downside.

All contracts deal with the direct aspects of the expected exchange and with unexpected consequences. Incomplete contracts lay out the general parameters of the exchange (the part that we shake hands over), while the unexpected consequences are covered by social norms governing what is appropriate and what is not. The social norms are what can motivate me to work with you, and what would establish goodwill in resolving problems that might arise.

As for complete contracts, they too specify the parameters of an exchange, but they don’t imply the same adherence to social norms. If something is left out, or if circumstances change, there’s no default to goodwill—it’s happy hunting season for all. When we use complete contracts as a basis for working together, we take away flexibility, reasonableness, and understanding and replace them with a narrow definition of expectations. That can be costly.

A CEO of a large Internet company recently told me about one of the worst decisions of his career. He instituted a very specific performance-evaluation matrix that would determine 10% of his employees’ compensation. Before this, the firm, like most, had a general agreement with its employees—they had to work hard, behave well, and were measured on certain goals. In return they were rewarded with salary increases, bonuses, and benefits. This CEO believed he could eliminate the uncertainty of the incomplete contract and better define ideal performance.

The complete-contract approach backfired. Employees became obsessively focused on meeting the specific terms of their contracts, even when it came at the expense of colleagues and the company. Morale sank, as did overall performance.

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Dan Ariely (dandan@duke.edu) is the James B. Duke Professor of Behavioral Economics at Duke University and the author of Predictably Irrational, Revised and Expanded Edition: The Hidden Forces That Shape Our Decisions and The Upside of Irrationality: The Unexpected Benefits of Defying Logic at Work and at Home (HarperCollins, 2010).